Corporate America announced 132 billion USD in share buybacks in the first month of 2023 - more than 300% higher than a year earlier. This activity has become increasingly popular over the past decade, and investors seem to be rewarding companies for this behaviour. Let us take a closer look at what a stock buyback is and the short- and long-term implications of this process.
Summary
- Share buybacks have become increasingly popular as a way for companies to take advantage of their undervalued shares and reward their shareholders.
- On the downside, stock buybacks may pressure the company's balance sheet and distort profitability metrics, such as ROE.
- By reducing the number of shares outstanding through buybacks, the company may be able to boost its EPS, artificially lowering its P/E ratio.
- Recently announced Meta's buyback resulted in its stock surging 23.28% in one day despite its cautious forecast for 2023 amid lowered advertising activity and numerous cost-cutting activities, including employee layoff.
- The US government has objected to the large-scale stock buybacks among corporations and has introduced a 1% excise tax starting from 1 January 2023.
A stock buyback is a process of buying back part of a listed company's shares outstanding from its shareholders. Stock buyback can be considered an alternative to cash dividends when it comes to returning part of a company's profits to its shareholders. The tax implications of share buybacks and dividends differ, so investors may prefer the former. While tax regulations vary widely between jurisdictions and may depend on how long the investor has held the asset and their income level, capital gains taxes are generally lower than taxes on dividend income.
What happened? Meta Platforms stock buyback
On 1 February, Meta Platforms (Facebook) announced a continuation of its stock buyback program. Meta reported an additional 40 billion USD increase in its share repurchase program during its quarterly earnings statement. The Q4 revenues were higher than expected (32.17 billion USD versus 31.53 billion USD), while EPS was well below expectations (1.76 versus 2.26). Despite the lower-than-expected EPS, the share price jumped a staggering 23.28% in one day (the best day in nearly a decade for META). Since the beginning of 2017, Meta has purchased back nearly 98 billion USD worth of stocks.
Source: TradingView
Why are share prices often increasing after a buyback announcement?
When the company undertakes a buyback programme, the number of shares outstanding is reduced while the company's value remains the same. This means that while the number of shares owned by a shareholder does not change (unless he participates in the stock buyback program), they are entitled to a greater portion of the company's value and profits. Let's see a simple example: a company's value is 1000 USD, and it has 100 shares outstanding (10 USD per share). If a company wants to buy back 10 shares, the value of the company remains the same, but there are now only 90 shares outstanding. The new value of each remaining share is now 11.11 USD.
Another important consideration is the improvement of all company metrics that use the number of shares outstanding, such as earnings per share (EPS) and, consequently, price to earnings (P/E). These metrics are crucial for many investors trying to evaluate whether the company's stock price is overvalued or not. Meanwhile, it may not be accurate to consider the share to be undervalued, as the falling number of shares outstanding automatically lowers the P/E ratio.
While using share buybacks simply to boost a company's various metrics may not be the best long-term strategy, there are many other reasons why companies engage in this activity. One important reason for share buybacks is to counterbalance the dilutive effect of exercising employees' stock options. Another reason companies buy back their shares is to take advantage of the moment they are considered undervalued. Consequently, when a company buys back its own shares, it could lead investors to believe that their shares may be undervalued in the eyes of management, thereby increasing their interest in the stock.
Other aspects of stock buybacks
Despite a possible positive effect on companies performing share buybacks, numerous aspects suggest otherwise.
One of the most obvious reasons may be the stock buyback effect on the company's balance sheet. Long-term use of share repurchases may lead the company's equity to become negative. The main reason for this is that most stock buybacks take place at a price considerably higher than the original issue price, meaning that the company will spend more money on the stock repurchasing than the amount that was contributed to its capital upon the share issue.
Diminishing equity leads to a distorted return-on-equity (ROE) ratio and many other metrics that use equity. As ROE is often used to assess the effectiveness of senior management, it is important to assess the reasons for rising ROE and other similar metrics. Many companies have declining or negative equity, making ROE impossible to calculate. It is worth remembering that although negative equity is not perceived as insolvency, it is called "technical insolvency" and could lead to numerous complications for the company's shareholders and management. Negative equity means that the company is operating solely on debt, which sometimes leads to an increased required rate of return due to the company's leverage or the unavailability of additional debt. It could also lead to a lower credit rating.
Furthermore, when a company engages in a stock buyback, it means that the funds used for the buyback would not be used for research and development projects, boosting output, or expanding its business in other ways. This may be a significant factor to consider before deciding on a long-term investment in a particular company.
Despite negative equity, numerous companies engage in continuous share repurchase schemes, such as Boeing, American Airlines, McDonald's, Starbucks, and many others. One such company – Lowe's Companies, Inc. – holds -12.8 billion USD in shareholder's equity and has been among the most aggressive share repurchasers in recent years. It has repurchased over 35 billion USD in shares over the last five years, which is around 28% of its market capitalization. Over the years, its liabilities have tripled, while its shareholders' equity was first reported negative in January 2022.
Source: Lowe's Companies Inc. financial reports, Graph: Author
As previously mentioned, stock buybacks boost EPS as it decreases the number of shares outstanding. The graph below shows the difference between the actual EPS and the EPS that would have been reported if the company had not carried out stock buybacks. To calculate the EPS without share buybacks, earnings in each period were divided by the number of shares outstanding at the end of FY2012 (the financial year ended in January 2013). At this time, there were 1,150 million shares outstanding versus 618 million shares outstanding at the end of Q3 2022.
Source: Lowe's Companies Inc. financial reports, Graph: Author
As the company becomes increasingly leveraged, it may face difficulties in operating during a market slowdown and, as discussed earlier, is not investing in new projects and the advancement of the business. The US government has introduced a 1% tax on this activity to discourage companies from doing stock buybacks.
Going back to Meta’s buyback
Meta and other well-known tech names are on the list of companies performing the largest stock buybacks in 2022. As one of the reasons that stock buybacks are conducted is to take advantage of the stock price dip, there is no surprise that 2022 saw so much activity in this field.
Meta is not close to negative equity, and as a cash-rich company, it may not have to worry about an increase in debt. Meta's ROE is 18.52%. Although it is considerably higher than the sector median ROE of 5.31%, it does not seem to be distorted as the company's equity has been increasing over the last decade. For comparison, a long-time share buyback fan, The Home Depot, only recently returned its shareholder's equity into the positive territory, and now its ROE is 1465.5%.
Meta's stock buyback in 2023 might look a bit different than last year, when the stock might have been considered undervalued. Since the low in 2022, Meta's share price has jumped by 116% - all within 3 months. Therefore, the buybacks in 2023 may be much harder to justify with the "undervalued stock" card.
The latest report showed that the company expects a drop in advertising due to rising interest rates and advertisers predicting a potential recession in the following months. To understand how important advertising is for Meta – it generates nearly 98% of the total revenue for the company. Furthermore, the company has announced its plans to cut spending in 2023, including the layoff of 11,000 employees and cancelling numerous existing projects. It is debatable how an additional 40 billion USD share buyback programme fits in with Meta's cost-cutting plans.
Conclusion
Stock buybacks have become increasingly popular in the corporate world. Although they are considered a way of rewarding shareholders, this activity may provide little fundamental benefit to the company's growth and productive capabilities in the long term. Furthermore, stock buybacks contribute a considerable part of the stock's demand, consequently raising its price. The elevated demand could only be maintained as long as the repurchases continue. In case of a market recession, when stock buybacks typically slow down, a drop in the stock's demand may pose additional pressure on its price, possibly having an opposite effect on its shareholders' wealth than expected.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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